I have written many articles on structured notes on this website over the past several years and fielded a lot of questions from readers of the site about these notes. These types of investments are not FDIC insured and ordinarily require a brokerage account with an investment bank like Morgan Stanley or Merrill Lynch to access. Hence, they are not for everyone. In fact, even for the most aggressive depositors and investors, they should only make up a small part of your portfolio. But, against the indisputable backdrop of rising yields and a steepening yield curve in 2017, it is a good time to take another look at these types of notes.
The interest rate-tied structured notes that are most prevalent are ordinarily tied to US Constant Maturity Swap Rates. The prospectus underlying these notes will always identify Reuters Screen ISDAFIX1 Page as the governing measurement, but the rates can be estimated by looking at the Constant Maturity Swap (CMS) rates at the bottom of this Federal Reserve webpage; the 2-year, 5-year, 10-year or 30-year swap is the difference between those CMS rates and the 6-month rate.
Interest rate-tied structured notes come in many different forms. For example, banks can issue notes that are tied to the 3-month CMS or LIBOR that have a cap and a floor (i.e., trade between, say, 3% and 10%). Just a few years ago, they issued notes that paid a fixed rate as high as 8% so long as the 6-month LIBOR stayed between 0 and 6%. However, since the long end is likely to rise much faster than the short end of the yield curve, investors and depositors should look predominantly at two categories in 2017: those that are based directly on the 10 year CMS swap rate and those that are based on a spread between a short swap rate (either 2-year or 5-year) and the 30-year CMS swap rate times a certain multiplier (usually 4x or 5x for the 2-year CMS-based notes, and as high as 8x or 9x on the 5-year CMS-based ones). There is always a second condition that notes will not pay interest for those days where an equity indices (usually the S&P 500 or Russell 2000) falls below a barrier level. The barrier level is ordinarily 75% of where the index is trading on the day the notes are priced. These notes ordinarily have a capped maximum interest rate that they can pay (between 9 and 12%) and often guarantee payment of that interest rate for the first year. These notes are usually very long term in duration and are sometimes callable after the first year.
In a rising interest rate environment, these notes are likely to produce strong interest as determined at each reset date. For example, those notes that are geared to the 2-30 CMS spread could easily get to their maximum capped interest rate as the spread gets to (and assuming it stays above) around 2%. An interest rate around 8% to 10% will probably be a nice interest rate to make over the next few years as rates rise, especially as those in bonds begin to lose money quickly. (Likewise, however, if we were to see an inverted yield curve, even one with much higher yields across the board, these spread notes could, in fact, yield nothing).
In addition to the interest rate risk, these interest-rate structured investments are not without other real risks. We define three main risks, although there are many more.
First, there is credit risk. These notes are tied to the debt of the issuing banks and are not FDIC insured. While Morgan Stanley, Chase or Citibank are pretty good credit risks, so too was Lehman Brothers as we entered 2008. Natixis, BNP Paribas, Societe Generale, Deutsche Bank and Credit Suisse are also big issuers, and while their notes can now be acquired at a discount, you should not be a purchaser of these notes at the moment unless you recognize and understand the credit risk that you are assuming.
Second, you have liquidity risk. These notes extend out for very long periods of time, and if you (or your estate) need to get out of them, you are going to get hosed. You can often benefit, however, from the hosing of others by buying notes through your broker on the secondary market. Under any circumstance, you should recognize that you are never likely to be liquid quickly, and even if the interest rate play that you want to make materializes and your notes are callable, you could still be holding the notes in some distant interest rate environment that you cannot really foresee at the moment.
Third, you have a risk of phantom income in the form of Original Issue Discount (OID) that your broker will be required to report on your 1099 by virtue of your ownership of these notes. OID is determined largely based on the discount that the issuer sells the notes to your broker and an amortization schedule in the prospectus, and may substantially reduce the effective income of these notes in the first few years after the notes’ original issuance. In order to fully understand the effects of OID on your taxable income, you will need to read the prospectus carefully and speak with your tax advisor.
Therefore, while interest rate-tied structured notes can be an effective way to generate yield in both a rising rate environment and a steepening yield curve, they are very risky and aren’t for everyone. Even the most aggressive investors should therefore keep a portfolio that is much more skewed towards cash accounts and very short term CDs.
Note: There has recently been a large issuance of interest-rate tied structured notes that involve a return of principal of less than 100% if a second defined barrier level is breeched on the date of maturity. For the same reasons that we strongly recommend that depositors avoid all equity-linked, commodity-linked and commodity-linked structured notes, interest rate-linked notes that do not guarantee 100% of principal at maturity should be categorically avoided in all circumstances.